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Mortgage rates have risen dramatically since the beginning of the year. The average 30-year fixed rate of 3.25% in January almost doubled to 6.00% in late June.
That increased monthly payment by $330 for individuals borrowing $200,000. This rate spike has led many to consider an option that hasn’t had a lot of discussion recently for their home borrowing needs – the Adjustable Rate Mortgage. According to the Mortgage Bankers Association, 49% of the mortgage purchase volume in the month of May was through Adjustable Rate Mortgages, or ARMs.
What is an adjustable rate mortgage?
Where a 30-year fixed rate maintains the same rate for the duration of the loan, an ARM is fixed for just a short period, typically one to seven years. After the initial period, the rate will adjust periodically for the remainder of the loan. The length of the fixed-rate period and frequency of adjusting can be found in the name of the ARM. For example, a 5/1 ARM has a fixed-rate for the first five years, and can adjust once per year after that.
The main benefit of an ARM is the initial rate is much lower than that of a 30-year fixed, usually 1.00% or more. That would save you over $1,400 a year on a $200,000 mortgage. While rates can increase over the life of the loan, borrowers have protection with various caps that restrict how much the rate can increase after the initial period.
An initial adjustment cap indicates how high rate can adjust the first time after the initial fixed rate period ends. For example, a 5/1 ARM at 4.50% with a 2% initial cap could see their rate increase as high as 6.50% for year six of the loan.
A periodic or subsequent adjustment cap indicates how high the rate can adjust each year after the initial adjustment.
A lifetime adjustment cap indicates the total amount of adjustment over the life of the loan. For example, here is the maximum interest rates for a borrower with a 5/1 ARM at 4.50% with a 2% initial cap, 1% subsequent cap, and 5% lifetime cap.
|
Years 1-5 |
4.50% |
|
Year 6 |
6.50% |
|
Year 7 |
7.50% |
|
Year 8 |
8.50% |
|
Year 9 – 30 |
9.50% |
Of course, rates can also decrease throughout the life of the loan depending on the overall rate environment.
Who should consider an ARM?
Anyone looking for the best mortgage interest rate should do their homework on an Adjustable-Rate Mortgage. Typically, ARMs make the most sense for borrowers who fall into the following categories:
First-time homebuyers. According to the National Association of Realtors, over 60% of homeowners under the age of 38 spent less than 8 years in their home before moving. New jobs, higher pay, and starting a family are all reasons why younger people typically stay in their “starter home” for a short period of time. Borrowers who don’t anticipate staying in their home longer than the fixed rate period of an ARM would benefit from the lower initial rate.
Military and professionals on the move. Individuals whose career takes frequently move from one area to the next are also prime candidates for an ARM. Much like first-time homebuyers, professionals on the move typically last less than six years at the same address, which would have them out of the home before the rates on an ARM start to adjust.
Buyers anticipating an income increase. Anticipating a drastic increase in pay can be a risky bet, and borrowers have to qualify for a mortgage based on current income. We recently spoke with a couple, Kevin and Shawna, who are looking to purchase a new home. Kevin works, while Shawna is a stay-at-home mom – for now. Their youngest child is in fifth grade, and Shawna is planning to go back to school by the time the child enters high school. This would add a big boost in take-home income before the end of the fixed term of the ARM.
While Adjustable-Rate Mortgages are not for everyone, they may be a smart option for you to drive down your monthly payment. Talk with your mortgage professional about your specific situation to see if it may be a right fit for you.
Michael Patterson is the Chief Branding Officer for Horizon Federal Credit Union. With 30 years’ banking experience, he has conducted financial literacy workshops to help individuals with banking, budgeting, and career development.
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